The Smooth Process Known as Russell Reconstitution

June means a lot of different things to different people. For my kids it’s get out of school time. For my wife it’s how long until my kids go back to school time. For me it is Russell Reconstitution time.

Before joining CBOE I would monitor the reconstitution process and try to trade around stocks that were going to be added or deleted from the Russell 2000. Now as an employee of CBOE I monitor the process since we are home for options trading on many FTSE Russell Indexes. Four of those indexes will be impacted through changes occurring on the market close on June 24th.

The specific indexes with brief descriptions are

Russell 2000 (RUT) – The Russell 2000 is basically the bottom 2/3rds of the largest 3000 stocks in the US. Being comprised of the smaller companies in the Russell 3000 makes RUT the standard small cap benchmark index in the US.

Russell 1000 (RUI) – RUI is comprised of the top 1/3rd of the stocks that comprise the Russell 3000. Comparisons are often made between RUI and RUT with respect to large cap and small cap performance.

Russell 1000 Growth (RLG) – RLG is best described as a Large Cap Growth index. Stocks in RLG generally have high price to book ratios and high forecasted earnings growth.

Russell 1000 Value (RLV) – stocks in the RLV would be considered Large Cap Value stocks that generally are not experiencing exceptional earnings growth but do have lower price to book ratios that stocks in RLG.

Each year FTSE Russell undergoes a four-week long process that involves updating or reconstituting the members of their indexes. The process takes longer than four-weeks, but the public part of the process involves three steps over a four-week period. The first step involves ranking stocks by market cap. This occurred on May 27th this year. The second step is sort of two mini steps as updates to the lists or any revisions are shared with the market place. This occurred on June 10th and again on June 17th this year. The final reconstituted indexes will take effect on the market close June 24th which is the last Friday of June.

The whole process is spelled out in a report that may be found at www.ftserussell.com. Since I’m focusing on the four indexes with options available for trading at CBOE I will offer a condensed version of the construction of those indexes in two parts below. First I’ll give an overview of the composition of the Russell 1000 and Russell 2000, then I’ll spend a little time on the Russell 1000 Growth and Value Indexes.

The Russell 1000 and Russell 2000 are basically constructed in two steps. The first step involves ranking the top 3000 stocks by market cap.  These stocks comprise what becomes the Russell 3000. Then these 3,000 stocks are ranked by market cap and a breakpoint is determined by the capitalization of the stock that is ranked 1,000. There is another step in this process, in order to keep the number of changes between the Russell 1000 and Russell 2000 at a relatively low level, there is a range of 5% set around the breakpoint level. If a company falls on the other side of the breakpoint relative to the current index it is a member of, but is within the 5% range it will not change index membership.

The Russell 1000 Growth and Russell 1000 Value Indexes are determined using the members of the Russell 1000 and then deciding whether certain financial characteristics define a stock as being growth or value.   FTSE Russell uses three factors: price to book, I/B/E/S 2 year growth, 5 year historical sales growth. Value stocks are determined through using price to book, while growth stocks are determined using I/B/E/S 2 year growth and 5 year historical sales growth statistics. Stocks are ranked on value and growth characteristics using a style index. These stocks are then finally designated either growth, value or both. That’s right, a stock may have both value and growth characteristics which would result in the stock being included in both indexes with a weighting that reflects their growth and value characteristics.

So a week from Friday RUT, RUI, RLG, and RLV will all change their composition on the market close. This occurs after diligent work by FTSE Russell analysts who have taken what could be a difficult process and made it a very smooth transition.